Are Crypto Riches Tax-Free?

With billions being made in the crypto-bubble, Uncle Sam wants his cut. Getting his hands on it will be another matter. In 2014, the IRS issued controversial guidance stating U.S. taxpayers should treat digital currencies as capital assets, provided they are convertible into traditional cash. (In other words, play money in an online game doesn't count.)

Aliza Grant, Forbes staff

(Credit: Aliza Grant, Forbes staff)

The upside of capital-asset treatment is that anyone who sells a digital position he's held for more than a year is taxed on his profit at the lower long-term capital gains rate--currently 0% to 20%. The downside is that traders who hold their positions for shorter periods are taxed on gains at ordinary federal income tax rates of up to 39.6%.

But an even bigger problem with the IRS' position is this: Anyone using digital coins to pay for some service online--say, buying data storage--would, it appears, have to treat each purchase as a capital sale. And if the value of the coin being spent has gone up since he acquired it, he'd have to report and pay tax on a gain. (By contrast, if you hold a conventional currency--say, euros or yen--and you happen to spend it after it has gained value against the dollar, the IRS doesn't consider that taxable income.)

Reporting on the taxpayer side isn't optional: Income is income, whether from trading stocks or Bitcoin or spending the latest token. The reality, however, is that there is no current requirement that cryptocurrency exchanges report transactions to the IRS the way brokers like Schwab must report stock sales on form 1099-B.

Is tax avoidance adding fuel to the current mania? Consider this: In 2016, only 802 individual tax returns out of the 132 million filed electronically with the IRS reported income related to cryptocurrencies.

(Credit: Aliza Grant, Forbes staff)

The government wants more compliance. Last November, the Department of Justice filed suit in federal court seeking to issue a summons forcing Coinbase to turn over records on all U.S. customers who transferred convertible virtual currency between December 31, 2013, and December 31, 2015.

The court sided with the IRS initially, but Coinbase--and Coinbase customers--have pushed back, delaying enforcement of the summons. Even if the IRS gets all those customers' names, however, it still has a big problem if it wants to tax all the crypto-gains: Much of the trading is done on overseas exchanges, and even more could migrate there.